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Can informal finance substitute for formal finance?

The fast growth of Chinese private sector firms is taken as evidence that it is alternative financing and governance mechanisms that support China’s growth. However, research results suggest that despite its weaknesses, financing from the formal financial system is associated with faster firm growth, whereas fund raising from alternative channels is not.

A large literature in law and finance has shown that development of formal financial institutions is associated with faster growth and better resource allocation. This literature has also recognized the existence and complementary role played by informal financial systems, especially in developing economies. Informal financing typically consists of small, unsecured, short term loans restricted to rural areas, agricultural contracts, households, individuals or small entrepreneurial ventures and helps in servicing the lower end of the market. Even in developed markets such as the US, there is a direct parallel with the prevalence of angel finance where high net-worth individuals, “angel investors”, provide initial funding to young new firms with modest capital needs until they are able to receive more formal venture capital financing. According to this view however, informal financial systems cannot substitute for formal financial systems because their monitoring and enforcement mechanisms are ill-equipped to scale up and meet the needs of the higher end of the market.

However, in an important branch of the literature, China is often mentioned as a counterexample to the findings in the finance and growth literature and its focus on formal systems. It is true that China is one of the fastest growing economies in the world, despite weaknesses in its formal banking system. The fast growth of Chinese private sector firms is taken as evidence that it is alternative financing and governance mechanisms that support China’s growth. In our recent research, we use detailed firm level survey data from the World Bank Investment Climate Surveys on 2400 firms in China to investigate which of the two views are consistent with the operation of the informal sector in China. Is the informal sector associated with high growth and profit reinvestment and does it serve as a substitute to the formal financial system or does the informal sector primarily serve the lower end of the market?

We find that in China, private firms’ use of bank financing is comparable to its use in other developing countries. The breakdown of non-bank financing sources shows greater differences. Compared to other countries, firms in our sample rely on a large informal sector and alternative financing channels. These other financing sources could well be the large underground lending in China.

However, we find that it is financing from formal bank sources that is positively associated with firm growth and reinvestment. Contrary to earlier findings, fund raising from informal channels is not associated with faster firm growth. To the extent that there are measurable benefits of informal financing, they arise only when retained earnings is classified as informal financing, as in some earlier studies. While we find the majority of firms that receive bank loans grow faster as a result, we do find a subpopulation of firms that do not. Firms that report that government help was instrumental in obtaining a bank loan do not show faster growth, higher reinvestment or productivity compared to firms that get bank loans without government help. However, these results do not make China an exception to the growth and finance literature. They are consistent with previous work showing the disadvantages of state-owned banking.Overall, our results suggest that even in fast growing economies like China where the formal financial system serves a small portion of the private sector due to a poorly developed financial and legal system, external finance from the formal financial system is associated with faster growth and higher profit reinvestment rates for those firms that receive it. We find no evidence that alternative financing channels are associated with higher growth. Our findings suggest that the role of reputation and relationship based informal financing and governance mechanisms in supporting the growth of private sector firms is likely to be limited and unlikely to substitute for formal mechanisms. These findings confirm the important role finance plays in development process and underline the importance of focusing on financial sector reforms.